New Rules Could Govern Sec. 41 Credit for Software
After much anticipation, the IRS has recently released their proposed regulations regarding the Section 41 research credit (REG- 153656–03) and which internal-use software types qualify for it. These new regulations are so far only a proposition and are not yet final. However, the IRS has stated that it won’t challenge return positions for taxpayers that are already applying these proposed rules.
In 2001, final regulations (T.D. 8930) regarding the Section 41 credit and internal-use software were released, but they were met with widespread disapproval from professionals. As a result, the IRS announced an advanced notice of proposed rule-making (ANPRM) in 2004. In the notice, the IRS stated that it would give consideration to the feedback it had received and devise a new set of regulation proposals.
The Purpose of the Regulations
The purpose of these proposed regulations is to differentiate between software that has been developed solely for use within a taxpayer’s business, which is not eligible for the credit, and external-use software, which is eligible for the credit in many cases.
Internal-use software is defined as computer software that has been designed for or by a taxpayer for the main purpose of simplifying and aiding their business functions. Common examples of these uses for this software include human resources, data processing, financial management, facilities management and support services.
Eligibility for Section 41 Research Credit
However, internal-use software may be eligible for the Section 41 research credit if certain set of requirements are met, known as a high-threshold-of-innovation test. In order to qualify, the software must adhere to these three criteria:
They must be innovative.
– This means the software must improve speed, cut costs or exhibit some other notable enhancement that is considerable and financially significant, or that the software has been deemed successful.
Development of the software must have involved a large financial risk.
– This means that the taxpayer must have invested significant resources into research and development, and because technology is risky, the taxpayer is uncertain that they will recover their development costs within a reasonable time frame.
The software may not be made available for profit without heavily modifying it.
– This means that the software is not allowed to be bought, licensed, used or leased for its intended function without changes that would meet the two above criteria.
Dual-Function Internal Software
In certain cases, dual-function internal software may also be eligible. This type of software serves administrative as well as general and non-general purposes. In order to qualify, the proposed regulations maintain that it must be proved that the software was not designed for internal use, which would not be eligible for the credit.
To do this, the taxpayer must indicate a subgroup of the dual-function software’s features that allow the taxpayer to communicate solely with third parties, or enable third parties to review data or launch actions (preamble, REG-153656-03).
How Much Credit Does the Taxpayer Receive
Furthermore, the proposed rules will offer a safety net that applies to the software, when a third-party subgroup can’t be determined, or to the remainder of the dual-function software once the third-party subgroup has been defined. Under this feature of the rules, one-quarter of a taxpayer’s research and expenses for developing the software’s dual-function subgroup is factored in when determining how much the taxpayer receives for the credit.
However, this is only if the research that went into development of the software’s dual-function aspects are considered eligible, and the use of dual-function features by either a third party or the taxpayer communicating with a third party comprises ten percent or more of the features’ use.
Currently, the IRS is welcoming feedback on any area of the proposed regulations. However, it is particularly interested to hear feedback on:
– How to handle and define connectivity programs that enable processes on one or more computers to cooperate over a network. This is often called middleware, bridging software or integration software
– The simplicity of gauging the reasonably expected use of software for the dual-function safe harbor, and
– Which situations and details, aside from the ones already laid out, would be important for deciding if internal-use software meets the criteria set by the innovation test.
When Changes Become Effective
While many people have asked to have these rules applied retroactively, the IRS has opted to make them apply only in the future. For this reason, the rules will only affect tax years on or after the date that the Federal Register makes them final. That said, taxpayers who are applying these proposed rules to their current taxes will not have their return positions challenged.
Furthermore, this new set of regulations invalidates the previous 2004 ANPRM for fiscal years starting on or later than January 20, 2015. This means that taxpayers currently have the option of using either the proposed or final regulations for 2001 until the IRS can finalize the new set.
With this in mind, did this article get you thinking about how to advise clients who use technology or create it? Can you at least do a bit more research to help them achieve their goals while getting the maximum tax credits for their use of specialized software?
Also, if you’re not filing taxes electronically on their behalf, you need to step up with this. If you efile 1099 and other tax documents, your clients should receive their refunds notably faster. I also suggest that you use eFile4Biz.com to file 1099 online. The time I save by using their SaaS platform allows me to focus on customers. Their short video below explains it all.
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